Nothing in tech feels like more of a bubble than YC demo day. While the average seed deal in 2012 was valued at around $6 million, YC deals are routinely two or three times that expensive.Hyper-expensive deals are a problem, but not so much so for investors. YC companies could easily be two or three times as likely to be successful as average startups, and as long as investors pick the good startups, they will do well regardless of the terms. YC has not yet proven to be a bubble; investors have done very well with these deals.
Instead, the main losers from these inflated valuations are the startup founders. Raising a seed round at a high valuation when you have relatively little traction is risky and damaging, and is generally done for the wrong reasons. Here are the main problems I've seen startups run into when they raise money at very high valuations.
Raising subsequent rounds gets much more difficult
You can usually only raise money on a promise once, and your seed round is the time to do it. This is your opportunity to partner with investors who want to invest in your team, your product, and your market. Investors will give you an implied valuation of millions of dollars in spite of the fact that little to no money is coming into your company.
The next round is not as forgiving. Series A investors do much deeper diligence on your revenues, operational costs, market potential, and key metrics, and they want to invest at a price that is (somewhat) grounded in reality. If you can't show investors serious traction 18 months after your seed round when you run out of money, you will get into trouble. You run the risk of raising a down round at a lower valuation (which brings on all kinds of problems), or not being able to raise more money at all.
Lower quality investors
Top tier investors often pay premiums to invest in good companies because they are actually very good. However, when a given startup artificially inflates its pricing relative to what it should be, it often ends up pushing out those high quality investors who know a good deal when they see one.
Another unfortunate consequence is that the investors you do get will be lower quality to you than they would be had you given them a better price. Because they will own a smaller stake in your company and feel less invested, they will be less incentivized to help you.
Waste of time
This is a really important one. Despite how it often seems, a startup CEO's main job is not actually to raise money; it's to lead the company to success. Fundraising is distracting from the important working of building a business, and should be done as quickly as possible.
When founders decide to raise at an obscene valuation, they can spend several weeks or months speaking to investors, and worse, all of their cognitive focus and emotional energy. Picking a reasonable valuation allows you get investors much more quickly so you can get back to building your business.
Just to drive home how insignificant the seed valuation of a startup is to the founders, here's a quick example.
If a startup raises a million dollars on a $4mm cap convertible note, it gives away 20%; if it raises a million on a $9mm cap note, it gives away 10%. For a founder who owns 30% of the company, we are talking about a difference between diluting down to 24% vs. 27%. *It just won't matter.* There will be a bigger variance in your eventual exit price based on the whims of your acquirer's M&A team that day, so forget about the equity.
Founders aim for high valuations so they can raise more money, suffer less dilution, and enjoy the internal satisfaction (or external competition with other founders) of running a valuable business.
Here is my advice: Founders, your outcome is binary. Either your startup will be a success and make you rich or it won't. Don't optimize for equity, optimize for success.